All About...
`
`the SForeign Cxchange Hlarket
`in the UnitedStates
`
`GAIN CAPITAL - EXHIBIT 1011
`
`Federal Reserve Bonk of New York
`
`198
`
`GAIN CAPITAL - EXHIBIT 1011
`
`

`

`ALL ABOUT...
`
`F O R E W O R D
`
`foreword
`
`Over the past forty years, the Federal Reserve Bank of New York has published
`
`monographs about the operation of the foreign exchange market in the United States.
`
`The first of these reports, The New York Foreign Exchange Market, by Alan Holmes, was
`
`published in 1959. The second, also entitled The New York Foreign Exchange Market,
`
`was written by Alan Holmes and Francis Schott and published in 1965. The third
`
`publication, Foreign Exchange Markets in the United States, was written by Roger
`
`Kubarych and published in 1978.
`
`Each of these publications presents a lucid
`and informed picture of the foreign exchange
`market and how it operates,
`filled with
`rich
`insights and reflecting a profound
`understanding of the market and its complex
`mechanisms. Roger Kubarych’s report, written
`twenty years ago, provided a valuable analysis
`of the foreign exchange market that is still read
`and widely appreciated by persons interested in
`gaining a deeper understanding of that market.
`
`But the foreign exchange market is always
`changing, always adapting to a shifting world
`economy and
`financial environment. The
`metamorphosis of the 1980s and ‘90s in both
`finance and technology has changed the structure
`of the market and its operations in profound
`ways. It is useful to reexamine the foreign
`exchange market from today’s perspective.
`
`The focus of the present book is once again
`on the U.S. segment of the global foreign
`exchange market. Chapters 1-3 describe the
`structure of
`the market and how it has
`changed. Chapters 4-6 comment on the main
`participant groups and the instruments that
`
`are traded. Chapters 7-8 look at foreign
`exchange trading from a micro, rather than
`macro, point of view—how an individual
`bank or other dealing firm sees things.
`Chapters 9-11 comment on some of
`the
`broader
`issues
`facing
`the
`international
`monetary system and how governments,
`central banks, and market participants
`operate within that system. This is followed by
`an epilogue, emphasizing that there are many
`unanswered questions, and that we can expect
`many further changes in the period ahead,
`changes that we cannot now easily predict.
`
`Markets go back a long time—in English
`law, the concept was recognized as early as the
`11th century—and it is interesting to compare
`today’s foreign exchange market with historical
`concepts. More than one hundred years ago,
`Alfred Marshall wrote that “a perfect market is
`a district, small or large, in which there are
`many buyers and many sellers, all so keenly on
`the alert and so well acquainted in one
`another’s affairs that the price of a commodity
`is always practically the same for the whole of
`the district.”
`
`1 l The Foreign Exchange Market in the United States
`
`

`

`foreword
`
`ALL ABOUT...
`
`Today’s over-the-counter global market in
`foreign exchange meets many of the standards
`that classical economists expected of a
`smoothly functioning and effective market.
`There are many buyers and many sellers.
`Entry by new participants is generally not too
`difficult. The over-the-counter market is
`certainly not confined to a single geographical
`area as the classical standards required.
`However, with the advance of technology,
`information
`is dispersed quickly and
`efficiently around the globe, with vast
`amounts of
`information on political and
`economic developments affecting exchange
`rates. As in commodity markets, identical
`products are being traded in financial centers
`all around the world. Essentially, the same
`marks, dollars, francs, and other currencies
`are being bought and sold, no matter where
`the purchase takes place. Traders in different
`centers are continuously in touch and buying
`and selling from each other. With trading
`centers open at the same time, there is no
`evidence of substantial price differences
`lasting more than momentarily.
`
`Not all features of today’s over-the-counter
`market fully conform to the classical ideals.
`There is not perfect “transparency,” or full and
`immediate disclosure of all trading activity.
`Individual traders know about the orders and
`the flow of trading activity in their own firms,
`but that information may not be known to
`everyone else
`in the market. However,
`transparency has increased enormously in
`recent years. With the growth of electronic
`dealing systems and electronic brokering
`
`systems, the price discovery process has
`become less exclusive and pricing information
`more broadly disseminated—at least for
`certain
`foreign exchange products and
`currency pairs. Indeed, by most measures, the
`over-the-counter foreign exchange market is
`regarded by observers as not only extremely
`large and liquid, but also efficient and
`smoothly functioning.
`
`Many persons, both within and outside the
`Federal Reserve,helped in the preparation of this
`book, through advice, criticism, and drafting.
`In the Federal Reserve, first and foremost, before
`his tragic death, Akbar Akhtar was a close
`collaborator on the project over an extended
`period, contributing to all aspects of the effort
`and helping to produce much of what is here.
`Dino Kos and his colleagues in the Markets
`Group were exceedingly helpful. Allan Malz
`contributed in many important ways. Robin
`Bensignor, John Kambhu, and Steven Malin
`also provided much valuable assistance, and Ed
`Steinberg’s contribution as editor was invaluable.
`At the Federal Reserve Board, Ralph Smith
`offered very useful suggestions and comments.
`
`Outside of the Federal Reserve, Michael
`Paulus of Bank of America contributed
`profoundly and in many ways to the entire
`project, both in technical matters and on
`questions of broader philosophy. Christine
`Kwon also assisted generously. Members of the
`trading room staff at Morgan Guaranty were
`also very helpful. At Fuji Bank, staff officials
`provided valuable assistance. Richard Levich
`provided very helpful comments.
`
`The Foreign Exchange Market in the United States l 2
`
`

`

`table of contents 1 of 3
`
`ALL ABOUT...
`
`C H A P T E R S
`
`wFOREWORD
`
`wONE-Trading Foreign Exchange:
`A Changing Market in a
`Changing World (cid:228) p. 3
`
`wTWO-Some Basic Concepts:
`Foreign Exchange, the Foreign
`Exchange Rate, Payment and
`Settlement Systems (cid:228) p. 9
`
`1. How the Global Environment Has Changed
`2. How Foreign Exchange Turnover Has Grown
`
`1. Why We Need Foreign Exchange
`2. What “Foreign Exchange” Means
`3. Role of the Exchange Rate
`Bilateral and Trade-Weighted Exchange Rates
`4. Payment and Settlement Systems
`Payments via Fedwire and CHIPS
`
`wTHREE-Structure of the
`Foreign Exchange Market
`(cid:228) p. 15
`
`1. It Is the World’s Largest Market
`2. It Is a Twenty-Four Hour Market
`3. The Market Is Made Up of an International Network of Dealers
`4. The Market’s Most Widely Traded Currency Is the Dollar
`5. It Is an “Over-the-Counter” Market With an “Exchange-Traded” Segment
`
`wFOUR-The Main Participants
`in the Market (cid:228) p. 23
`
`wFIVE-Main Instruments:
`Over-the-Counter Market
`(cid:228) p. 31
`
`1. Foreign Exchange Dealers
`2. Financial and Nonfinancial Customers
`3. Central Banks
`Classification of Exchange Rate Arrangements, September 1997
`4. Brokers
`In the Over-the-Counter Market
`Voice Brokers
`Automated Order-Matching or Electronic Broking Systems
`In the Exchange-Traded Market
`
`1. Spot
`There Is a Buying Price and a Selling Price
`How Spot Rates Are Quoted: Direct and Indirect Quotes,
`European and American Terms
`There Is a Base Currency and a Terms Currency
`Bids and Offers Are for the Base Currency
`Quotes Are in Basis Points
`Cross Rate Trading
`Deriving Cross Rates From Dollar Exchange Rates
`2. Outright Forwards
`Relationship of Forward to Spot—Covered Interest Rate Parity
`Role of the Offshore Deposit Markets for Euro-Dollars and Other Currencies
`How Forward Rates Are Quoted by Traders
`Calculating Forward Premium/Discount Points
`Non-Deliverable Forwards (NDFs)
`
`The Foreign Exchange Market in the United States
`
`1
`
`3
`4
`
`9
`9
`9
`10
`11
`12
`
`15
`16
`18
`19
`21
`
`23
`24
`25
`26
`27
`27
`29
`29
`30
`
`31
`32
`
`32
`33
`33
`34
`34
`34
`36
`36
`37
`38
`38
`39
`
`

`

`ALL ABOUT...
`
`table of contents 2 of 3
`
`C H A P T E R S
`
`wFIVE-Main Instruments:
`Over-the-Counter Market
`(continued from last page)
`
`3. FX Swaps
`Why FX Swaps Are Used
`Pricing FX Swaps
`Some Uses of FX Swaps
`Calculating FX Swap Points
`4. Currency Swaps
`Purposes of Currency Swaps
`5. Over-the-Counter Foreign Currency Options
`The Pricing of Currency Options
`Delta Hedging
`Put-Call Parity
`How Currency Options Are Traded
`Options Combinations and Strategies
`Foreign Exchange Options Galore
`
`wSIX-Main Instruments:
`Exchange-Traded Market
`(cid:228) p. 59
`
`wSEVEN-How Dealers Conduct
`Foreign Exchange Operations
`(cid:228) p. 67
`
`1. Exchange-Traded Futures
`Development of Foreign Currency Futures
`Quotes for Foreign Currency Futures
`2. Exchange-Traded Currency Options
`3. Linkages
`Linkages Between Main Foreign Exchange Instruments in Both
`OTC and Exchange-Traded Markets
`
`1. Trading Room Setup
`2. The Different Kinds of Trading Functions of a Dealer Institution
`3. Trading Among Major Dealers—Dealing Directly and Through Brokers
`Mechanics of Direct Dealing
`Mechanics of Trading Through Brokers: Voice Brokers and Electronic
`Brokering Systems
`4. Operations of a Foreign Exchange Department
`5. Back Office Payments and Settlements
`
`wEIGHT-Managing Risk in
`Foreign Exchange Trading
`(cid:228) p. 77
`
`1. Market Risk
`Measuring and Managing Market Risk
`Value at Risk
`2. Credit Risk
`Settlement Risk—A Form of Credit Risk
`Arrangements for Dealing with Settlement Risk
`Sovereign Risk—A Form of Credit Risk
`Group of Thirty Views on Credit Risk
`3. Other Risks
`
`40
`40
`41
`41
`43
`44
`44
`45
`48
`51
`52
`52
`53
`54
`
`59
`62
`63
`64
`65
`
`65
`
`67
`68
`69
`69
`
`71
`73
`75
`
`77
`78
`78
`80
`81
`82
`83
`83
`83
`
`The Foreign Exchange Market in the United States
`
`

`

`table of contents 3 of 3
`
`ALL ABOUT...
`
`C H A P T E R S
`
`wNINE-Foreign Exchange
`Market Activities of the U.S.
`Treasury and the Federal
`Reserve (cid:228) p. 85
`
`1. U.S. Foreign Exchange Operations Under Bretton Woods
`Authorization and Management of Intervention Operations
`2. U.S. Foreign Exchange Operations Since the Authorization in 1978
`of Floating Exchange Rates
`3. Executing Official Foreign Exchange Operations
`Techniques of Intervention
`4. Reaching Decisions on Intervention
`5. Financing Foreign Exchange Intervention
`
`wTEN-Evolution of the
`International Monetary
`System (cid:228) p. 97
`
`1. The Gold Standard, 1880-1914
`2. The Inter-War Period, 1919-1939
`3. The Bretton Woods Par Value Period, 1946-1971
`4. The Floating Rate Period, 1971 to Present
`
`wELEVEN-The Determination of
`Exchange Rates (cid:228) p. 107
`
`wTWELVE-Epilogue:
`What Lies Ahead? (cid:228) p. 119
`
`wFOOTNOTES
`
`1. Some Approaches to Exchange Rate Determination
`The Purchasing Power Parity Approach
`The Balance of Payments and the Internal-External Balance Approach
`The Monetary Approach
`The Portfolio Balance Approach
`Measuring the Dollar’s Equilibrium Value: A Look at Some Alternatives
`How Good Are the Various Approaches?
`2. Foreign Exchange Forecasting in Practice
`Assessing Factors That May Influence Exchange Rates
`3. Official Actions to Influence Exchange Rates
`Continuing Close G7 Cooperation in Exchange Markets
`
`1. Global Financial Trends
`Introduction of the Euro
`Increased Trading in Currencies of Emerging Market Countries
`2. Shifting Structure of the Foreign Exchange Market
`Consolidation and Concentration
`Automated Order-Matching Systems
`3. New Instruments, New Systems
`
`86
`87
`
`88
`91
`92
`93
`94
`
`97
`99
`100
`103
`
`107
`107
`108
`109
`110
`111
`112
`113
`114
`115
`117
`
`119
`119
`120
`121
`121
`121
`122
`
`125
`
`The Foreign Exchange Market in the United States
`
`

`

`trading foreign exchange: a changing market in a changing world
`
`ALL ABOUT...
`
`C H A P T E R 1
`
`In a universe with a single currency, there would be no foreign exchange market, no
`
`foreign exchange rates, no foreign exchange. But in our world of mainly national
`
`currencies, the foreign exchange market plays the indispensable role of providing the
`
`essential machinery for making payments across borders, transferring funds and
`
`purchasing power from one currency to another, and determining that singularly
`
`important price, the exchange rate. Over the past twenty-five years, the way the market
`
`has performed those tasks has changed enormously.
`
`1. HOW THE GLOBAL ENVIRONMENT HAS CHANGED
`
`increasing
`Since the early 1970s, with
`internationalization of financial transactions,
`the foreign exchange market has been
`profoundly transformed, not only in size, but
`in coverage, architecture, and mode of
`operation. That transformation is the result of
`structural shifts in the world economy and in
`the international financial system. Among
`the major developments that have occurred
`in the global financial environment are the
`following:
`
`wA basic change in the international monetary
`system, from the fixed exchange rate “par
`value” requirements of Bretton Woods that
`existed until the early 1970s to the flexible
`legal structure of today, in which nations can
`choose to float their exchange rates or to
`follow other exchange rate regimes and
`practices of their choice.
`
`financial deregulation
`w A tidal wave of
`throughout the world, with massive elimi-
`nation of government controls and restrictions
`
`in nearly all countries, resulting in greater
`freedom
`for national and
`international
`financial transactions, and in greatly increased
`competition among financial institutions, both
`within and across national borders.
`
`institu-
`toward
`fundamental move
`w A
`tionalization and
`internationalization of
`savings and investment, with funds managers
`and institutions around the globe having
`vastly larger sums available, which they are
`investing and diversifying across borders
`and currencies in novel ways and in ever
`larger amounts as they seek to maximize
`returns.
`
`w A broadening and deepening trend toward
`international trade liberalization, within a
`framework of multilateral trade agreements,
`such as the Tokyo and the Uruguay Rounds of
`the General Agreement on Tariffs and Trade,
`the North American Free Trade Agreement,
`and U.S. bilateral trade initiatives with China,
`Japan, and the European Union.
`
`3 l The Foreign Exchange Market in the United States
`
`

`

`trading foreign exchange: a changing market in a changing world
`
`ALL ABOUT...
`
`w Major advances in technology, making
`possible instantaneous real-time transmission of
`vast amounts of market information worldwide,
`immediate and sophisticated manipulation of
`that information to identify and exploit market
`opportunities,and rapid and reliable execution of
`financial transactions—all occurring with a level
`of efficiency and reduced costs not dreamed
`possible a generation earlier.
`
`w Breakthroughs in the theory and practice of
`finance, resulting not only in the development
`of innovative new financial instruments and
`derivative products, but also in advances in
`thinking that have changed our understanding
`of the financial system and our techniques for
`operating within it.
`
`The common theme underlying all of these
`developments is the role of markets—the growth
`and development of markets, enhanced freedom
`and competition in markets, improvements in the
`efficiency of markets,increased reliance on market
`forces and mechanisms, and the creation of better
`market techniques and instruments.
`
`The interplay of these forces, feeding off each
`other in a dynamic and synergistic way, created a
`global environment of creativity and ferment. In
`the 1970s, exchange rates became more volatile
`and imbalances in international payments grew
`much larger for well-known reasons: the advent of
`
`a floating exchange rate system, deregulation,
`and major macroeconomic shifts in the world
`economy. That caused financing needs to
`expand, which—at a time of rapid technological
`advance—provided
`fertile ground
`for
`the
`development of new financial products and
`mechanisms. These innovations helped market
`participants circumvent existing controls and
`encouraged further moves toward deregulation,
`which led to additional new products, facilitated
`the financing of still larger imbalances, and
`encouraged a trend toward institutionalization
`of savings and diversification of investment.
`Financial markets grew progressively larger and
`more sophisticated, integrated, and efficient.
`
`In that environment, foreign exchange trading
`increased rapidly and changed intrinsically.
`The market has expanded from one of banks to
`one in which many other kinds of financial and
`non-financial institutions also participate—
`including nonfinancial corporations, investment
`firms, pension funds, and hedge funds. Its
`focus has broadened from servicing importers
`and exporters to handling the vast amounts of
`overseas investment and other capital flows that
`currently take place. It has evolved from a series
`of loosely connected national financial centers to
`a single integrated international market that
`plays a far more extensive and direct role in our
`economies, affecting all aspects of our lives and
`our prosperity.
`
`2. HOW FOREIGN EXCHANGE TURNOVER HAS GROWN
`
`In 1998, the Federal Reserve’s most recently
`published survey of reporting dealers in
`the United States estimated that foreign
`exchange turnover in the U.S. market was
`$351 billion a day, after adjustments for
`
`double counting. That total is an increase of
`43% above the estimated turnover in 1995
`and more than 60 times the turnover in 1977,
`the first year for which roughly comparable
`survey data are available.
`
`The Foreign Exchange Market in the United States l 4
`
`

`

`ALL ABOUT...
`
`trading foreign exchange: a changing market in a changing world
`
`In some ways, this estimate understates the
`growth and the present size of the U.S. foreign
`exchange market. The $351 billion estimated
`daily turnover covered only the three traditional
`instruments in the “over-the-counter” (OTC)
`market—spot, outright forwards, and foreign
`exchange (FX) swaps; it did not include over-the-
`counter currency options and currency swaps
`traded in the OTC market, which totaled about
`$32 billion a day in notional value (or face value)
`in 1998. Nor did it include the two products
`traded, not “over-the-counter,” but in organized
`exchanges— currency futures and exchange-traded
`currency options, for which the notional value of
`the turnover was perhaps $10 billion per day.1
`
`The global foreign exchange market also has
`shown phenomenal growth. In 1998, in a survey
`under the auspices of the Bank for International
`Settlements (BIS), global turnover of reporting
`dealers was estimated at about $1.49 trillion
`per day for the traditional products, plus an
`
`additional $97 billion for over-the-counter
`currency options and currency swaps, and a
`further $12 billion for currency instruments
`traded on the organized exchanges. In the
`traditional products, global foreign exchange
`turnover, measured in current exchange rates,
`increased by more than 80 percent between
`1992 and 1998.
`
`The expansion in foreign exchange turnover,
`in the United States and globally, reflects the
`continuing growth of international trade and
`the prodigious expansion in global finance
`and investment during recent years. With
`respect to trade, the dollar value of United
`States international transactions in goods and
`services—the sum of exports and imports—
`tripled between 1980 and 1995 to around 15 times
`its 1970 level. International trade in the global
`economy also has expanded at a rapid pace.World
`merchandise trade is now more than 2½ times its
`1980 level (Figure 1-1).
`
`F I G U R E 1 - 1
`
`U.S. and World Merchandise Trade, 1970-95
`
`Billions of dollars
`1,500
`U.S.
`
`1,200
`
`900
`
`600
`
`300
`
`0
`
`1970
`
`1980
`
`1990
`
`1995
`
`Billions of dollars
`10,000
`World
`
`8,000
`
`6,000
`
`4,000
`
`2,000
`
`0
`
`1970
`
`1980
`
`1990
`
`1995
`
`Note: Merchandise trade is the sum of exports and imports of goods.
`
`5 l The Foreign Exchange Market in the United States
`
`

`

`trading foreign exchange: a changing market in a changing world
`
`ALL ABOUT...
`
`Merchandise Trade Balance
`
`Billions of U.S. dollars
`200
`150
`100
`50
`
`Japan
`
`Germany
`
`United States
`
`0
`-50
`
`-100
`-150
`-200
`
`1970
`
`1975
`
`1980
`
`1985
`
`1990
`
`1995
`
`Note: Merchandise trade balance is the gap between exports and imports of goods.
`
`U.S. International Capital Flows, 1970-95 (Annual Rate)
`
`Billions of dollars
`300
`Inflows
`
`Billions of dollars
`300
`Outflows
`
`250
`
`200
`
`150
`
`100
`
`50
`
`0
`
`1970-75
`
`1976-85
`
`1986-95
`
`1995
`
`250
`
`200
`
`150
`
`100
`
`50
`
`0
`
`1970-75
`
`1976-85
`
`1986-95
`
`1995
`
`Note: Both inflows and outflows of capital exclude official capital movements.
`
`But international trade cannot account for
`the huge increase in the U.S. foreign exchange
`turnover over the past twenty-five years. The
`enormous expansion of international capital
`transactions, both here and abroad, has been a
`dominant force. U.S. international capital inflows,
`including sales of U.S. bonds and equities
`
`factories
`to foreigners, acquisition of U.S.
`by foreigners, and bank deposit inflows, have
`averaged more than $180 billion per year since the
`mid-80s.
`
`Large and persistent external trade and
`payments deficits in the United States and
`
`The Foreign Exchange Market in the United States l 6
`
`

`

`ALL ABOUT...
`
`trading foreign exchange: a changing market in a changing world
`
`F I G U R E 1 - 2
`
`International Securities Markets
`
`Billions of dollars
`2,500
`International Bond Issues*
`
`Percent of GDP
`1980
`1995***
`200
`Cross-Border Securities Transactions**
`
`2,000
`
`1,500
`
`1,000
`
`500
`
`0
`
`1985
`
`1995
`
`150
`
`100
`
`50
`
`0
`
`U.S.
`
`Japan
`
`Germany
`
`*Outstanding amount of international bond issues at end-period.
`**Gross purchases and sales of securities between residents and non-residents.
`***U.S. values are for 1994.
`
`corresponding surpluses abroad have contributed
`to the growth in financing. Through much of the
`period since 1983, the United States has recorded
`trade deficits in the range of $100-$200 billion per
`year, while Japan and, to a lesser extent, Germany
`have registered substantial trade surpluses. In
`contrast, all three countries experienced only
`modest trade deficits or surpluses through the
`1960s and early 1970s.
`
`The internationalization of financial activity
`has increased rapidly. Cross-border bank claims
`are now nearly five times the level of 15 years
`ago; as a percentage of the combined GDP of
`the OECD countries, these claims have risen
`from about 25 percent in 1980 to about 42
`
`percent in 1995. During that same period, cross-
`border securities transactions in the three
`largest economies—United States, Japan, and
`Germany—expanded from less than 10 percent
`of GDP to around 70 percent of GDP in Japan
`and to well above 100 percent of GDP in
`Germany and the United States (Figure 1-2).
`Annual issuance of international bonds has
`more than quadrupled during the past ten years
`(Figure 1-2). Between 1988 and 1993, securities
`settlements through Euroclear and Cedel—the
`two main Euro market clearing houses—
`increased six-fold.
`
`All of this provided fertile ground for growth
`in foreign exchange trading.
`
`7 l The Foreign Exchange Market in the United States
`
`

`

`some basic concepts: foreign exchange,
`the foreign exchange rate, payment and settlement systems
`
`ALL ABOUT...
`
`C H A P T E R 2
`
`1. WHY WE NEED FOREIGN EXCHANGE
`
`Almost every nation has its own national
`currency or monetary unit—its dollar, its peso,
`its rupee—used for making and receiving
`payments within its own borders. But foreign
`currencies are usually needed for payments
`across national borders. Thus, in any nation
`whose residents conduct business abroad or
`
`engage in financial transactions with persons in
`other countries, there must be a mechanism for
`providing access to foreign currencies, so that
`payments can be made in a form acceptable to
`foreigners. In other words, there is need for
`“foreign exchange” transactions—exchanges of
`one currency for another.
`
`2. WHAT “FOREIGN EXCHANGE” MEANS
`
`“Foreign exchange” refers to money denomi-
`nated in the currency of another nation or
`group of nations. Any person who exchanges
`money denominated in his own nation’s
`currency for money denominated in another
`nation’s currency acquires foreign exchange.
`That holds true whether the amount of the
`transaction is equal to a few dollars or to
`billions of dollars; whether the person
`involved is a tourist cashing a traveler’s check
`in a restaurant abroad or an
`investor
`exchanging hundreds of millions of dollars for
`the acquisition of a foreign company; and
`whether the form of money being acquired
`is foreign currency notes, foreign currency-
`denominated bank deposits, or other short-
`term claims denominated in foreign currency.
`A foreign exchange transaction is still a shift
`of funds, or short-term financial claims, from
`one country and currency to another.
`
`Thus, within the United States, any money
`denominated in any currency other than the
`
`U.S. dollar is, broadly speaking, “foreign
`exchange.”
`
`Foreign exchange can be cash, funds available
`on credit cards and debit cards, traveler’s checks,
`bank deposits, or other short-term claims. It is
`still “foreign exchange” if it is a short-term
`negotiable financial claim denominated in a
`currency other than the U.S. dollar.
`
`But, in the foreign exchange market described
`in this book—the international network of major
`foreign exchange dealers engaged in high-volume
`trading around the world—foreign exchange
`transactions almost always take the form of an
`exchange of bank deposits of different national
`currency denominations. If one bank agrees to
`sell dollars for Deutsche marks to another bank,
`there will be an exchange between the two parties
`of a dollar bank deposit for a DEM bank deposit.
`In this book, “foreign exchange” means a bank
`balance denominated in a foreign (non-U.S.
`dollar) currency.
`
`3. ROLE OF THE EXCHANGE RATE
`The exchange rate is a price—the number of units
`currency. There are scores of “exchange rates”
`for the U.S. dollar. In the spot market, there is an
`of one nation’s currency that must be surrendered
`exchange rate for every other national currency
`in order to acquire one unit of another nation’s
`
`9 l The Foreign Exchange Market in the United States
`
`

`

`some basic concepts: foreign exchange,
`the foreign exchange rate, payment and settlement systems
`
`ALL ABOUT...
`
`traded in that market, as well as for various
`composite currencies or constructed monetary
`units such as the International Monetary Fund’s
`“SDR,” the European Monetary Union’s “ECU,”
`and beginning in 1999, the “euro.” There are
`also various “trade-weighted” or “effective” rates
`designed to show a currency’s movements against
`an average of various other currencies (see
`Box 2-1). Quite apart from the spot rates, there
`are additional exchange rates for other delivery
`dates,
`in the forward markets. Accordingly,
`although we talk about the dollar exchange rate in
`
`B O X 2 - 1
`
`BILATERAL AND TRADE-WEIGHTED
`EXCHANGE RATES
`
`Market trading is bilateral, and spot and
`forward market exchange rates are quoted
`in bilateral terms—the dollar versus the
`pound, franc, or peso. Changes in the
`dollar’s average value on a multilateral
`basis—(i.e., its value against a group or
`basket of currencies) are measured by
`using various statistical indexes that have
`been constructed to capture the dollar’s
`movements on a trade-weighted average,
`or effective exchange rate basis. Among
`others, the staff of the Federal Reserve
`Board of Governors has developed and
`regularly publishes such indexes, which
`measure the average value of the dollar
`against the currencies of both a narrow
`group and a broad group of other
`countries. Such
`trade-weighted and
`other indexes are not traded in the OTC
`spot or forward markets, where only
`the constituent currencies are traded.
`However, it is possible to buy and sell
`certain dollar index based futures and
`exchange-traded options in the exchange-
`traded market.
`
`the market, and it is useful to do so, there is no
`single, or unique dollar exchange rate in the
`market, just as there is no unique dollar interest
`rate in the market.
`
`A market price is determined by the inter-
`action of buyers and sellers in that market, and a
`market exchange rate between two currencies is
`determined by the interaction of the official and
`private participants in the foreign exchange rate
`market. For a currency with an exchange rate that
`is fixed, or set by the monetary authorities,
`the central bank or another official body is a key
`participant in the market,standing ready to buy or
`sell the currency as necessary to maintain the
`authorized pegged rate or range. But in the United
`States, where the authorities do not intervene in
`the foreign exchange market on a continuous
`basis to influence the exchange rate, market
`participation
`is made up of
`individuals,
`nonfinancial firms, banks, official bodies, and
`other private institutions from all over the world
`that are buying and selling dollars at that
`particular time.
`
`The participants in the foreign exchange
`market are thus a heterogeneous group. Some
`of the buyers and sellers may be involved in
`the “goods” market, conducting international
`transactions for the purchase or sale of
`merchandise. Some may be engaged in “direct
`investment” in plant and equipment, or in
`“portfolio investment,” dealing across borders
`in stocks and bonds and other financial
`assets, while others may be in the “money
`market,” trading short-term debt instru-
`ments internationally. The various investors,
`hedgers, and speculators may be focused on
`any time period, from a few minutes to several
`years. But, whether official or private, and
`whether their motive be investing, hedging,
`speculating, arbitraging, paying for imports,
`or seeking to influence the rate, they are all
`part of the aggregate demand for and supply
`
`The Foreign Exchange Market in the United States l 10
`
`

`

`ALL ABOUT...
`
`some basic concepts: foreign exchange,
`the foreign exchange rate, payment and settlement systems
`
`of the currencies involved, and they all play a
`role in determining the market exchange rate
`at that instant.
`
`Given the diverse views, interests, and
`time frames of the participants, predicting
`the future course of exchange rates is a
`particularly complex and uncertain business.
`At the same time, since the exchange rate
`
`influences such a vast array of participants
`and business decisions,
`it is a pervasive
`and singularly
`important price
`in an
`open economy, influencing consumer prices,
`investment decisions, interest rates, economic
`growth,
`the
`location of
`industry, and
`much else. The role of the foreign exchange
`market in the determination of that price is
`critically important.
`
`4. PAYMENT AND SETTLEMENT SYSTEMS
`
`Just as each nation has its own national
`currency, so also does each nation have
`its own payment and settlement system—
`that is,
`its own set of
`institutions and
`legally acceptable arrangements for making
`payments and executing financial transac-
`tions within that country, using its national
`currency. “Payment” is the transmission of an
`instruction to transfer value that results from a
`transaction in the economy, and “settlement”
`is the final and unconditional transfer of
`the value specified in a payment instruction.
`Thus, if a customer pays a department store
`bill by check, “payment” occurs when the
`check is placed in the hands of the depart-
`ment store, and “settlement” occurs when the
`check clears and the department store’s bank
`account is credited. If the customer pays the
`bill with cash, payment and settlement are
`simultaneous.
`
`When two traders enter a deal and agree to
`undertake a foreign exchange transaction, they
`are agreeing on the terms of a currency exchange
`and committing the resources of their respective
`institutions to that agreement. But the execution
`of that exchange—the settlement—does not
`take place until later.
`
`Executing a foreign exchange transaction
`requires two transfers of money value,
`in
`opposite directions, since
`it
`involves the
`exchange of one national currency for another.
`Execution of
`the transaction engages the
`payment and settlement systems of both
`nations, and those systems play a key role in the
`operations of the foreign exchange market.
`
`Payment systems have evolved and grown
`more sophisticated over time. At present, various
`forms of payment are legally acceptable in the
`United States—payments can be made, for
`example, by cash, check, automated clearinghouse
`(a mechanism developed as a substitute for certain
`forms of paper payments), and electronic funds
`transfer (for large value transfers between banks).
`Each of these accepted forms of payment has its
`own settlement techniques and arrangements.
`
`By number of transactions, most payments
`in the United States are still made with cash
`(currency and coin) or checks. However, the
`electronic funds transfer systems, which
`a